Wednesday, January 16, 2013

A Balanced Balance-of-Payments Diagnosis of the Euro Crisis

It is developed by Galina Hale,
a senior economist in the Economic Research Department of the Federal Reserve
Bank of San Francisco in a FRBSF Economic Letter January 14, 2013 article, “Balance
of Payments in the European Periphery.”

Excerpts:

“Greece, Italy, Ireland,
Portugal, and Spain (GIIPS) are going through balance of payments crises
stemming from persistent current account deficits and net private capital
outflows. These crises are like the sudden stops in capital flows that have
previously taken place in some emerging market economies. Traditionally, such
crises triggered currency collapses, which restored external accounts to
sustainable paths. For GIIPS, that can’t happen as long as they stay in the
euro area.

(….)

The 2007–08
global financial crisis hit cross-border capital flows hard, but GIIPS were not
initially affected more than other countries. However, in 2009–10, a sudden
stop in private capital flows took place as it became apparent that the
sovereign debt of some periphery countries might not be sustainable. The credit
ratings of Greece, Portugal, and Ireland were marked down, and spreads on their
government debt relative to German debt began to rise. If these countries had not
been euro-area members, their current accounts would have adjusted, most likely
through a currency crisis and rapid depreciation. Instead, these countries
remained in the euro area and continued to run current account deficits,
despite rapidly falling private capital inflows, and, in some cases, capital
flight.

How was that possible? In
essence, public capital replaced private capital. As private capital flows to
GIIPS fell, they were replaced by growing liabilities of the central banks of
GIIPS to the European Central Bank and the central banks of individual
euro-area countries, a network known as the Eurosystem.

(…)

The ability
to continue running current account deficits without private capital inflows
has allowed GIIPS to avoid balance of payments crises, giving them
opportunities to gradually adjust their external accounts.

Of course,
gradual current account adjustment is generally preferable to abrupt
rebalancing. This is especially true for GIIPS because exchange rate adjustment
is not an option as long as these countries remain in the euro area.
Nevertheless, to greater or lesser extents, the European peripheral countries
have to go through painful adjustments similar to those experienced by other
countries in the throes of balance of payments crises. For current accounts to
return to surplus, the competitiveness of GIIPS within the euro area must be
restored, which means wages have to fall relative to those in Germany.

Some of these adjustments have
already taken place over the past two years. As Figure 2 shows, current account
deficits of GIIPS have shrunk. Except in Italy, real wages have fallen about 5%
since 2010, and a lot more in Greece. However, for GIIPS to return to
sustainable growth paths, further adjustments may be necessary. In previous
emerging-market balance-of-payments crises, current account reversals were as
much as three times larger than the adjustment registered so far by GIIPS. In
some cases, real wages plunged 20–25%. In addition, the sovereign debt and
banking problems of GIIPS must still be resolved.”

My comment: Can it be done while the current deflationary
policies contribute to shrinking the economies of the GIIPS, and thus
deteriorate the Debt/GDP ratios as well as destroy social and political
cohesion?

It must also be understood that
the initial disequilibrium inflow of capital in the south was largely a result
of a same nominal ECB interest rate applied to countries with quite different
inflation rates. Negative real interest rates in GIIPS made heavy borrowing attractive
for investment and speculation purposes in these countries and determined the
excessive capital inflows that pushed balance sheets (public and private) into
highly risky zones.

Even if these balance sheets are
returned to equilibrium through the current painful (and relatively slow) deflationary adjustment,
what will happen in the future when inflation rates diverge again, as they did
in the past after the austerity adjustment period required for the entry into the
Eurozone? Very open economies cannot easily accommodate shocks and divergences without a flexible
exchange rate.

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About Me

As a professor of economics, my main specialization fields are in the theory and strategy of the firm, and the theory and applications of public choice (political economy).
I also do consulting work in these fields.
For more information on my work go to my homepage: http://jeanjacques.rosa.pagesperso-orange.fr/
and my SSRN author page: http://ssrn.com/author=471576.
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